YYY Vs. PCEF: Battle Of Closed-End Funds

February 26, 2014

Competing fund-of-funds ETFs signal CEFs may be heating up.

In an era where investors are looking for alternative sources of income that go beyond a traditional allocation to bonds, ETFs that invest in closed-end funds (CEFs) have found a growing following. Their appeal essentially centers on the relatively high income they are known to deliver.

In this small corner of the ETF market, there are two major funds competing for investor dollars. The PowerShares CEF Income Composite Portfolio (PCEF) is the older of the two, having been around now for four years, and boasting nearly $505 million in assets. In the past year, investors have poured a net of about $125 million into the fund as it rallied.

Competing against PCEF is the seven-month-old YieldShares High Income ETF (YYY), which came to market as the result of a soft closure of an oil sands ETF that went by the ticker “SNDS.” YYY has gathered just under $24 million in total assets.

The two funds set out to capture the income potential of the closed-end fund space, but they go about it differently, even if their performance over the past six months has been very similar. PCEF saw total returns of 8.2 percent, while YYY returned 8.4 percent in the period.


Chart courtesy of StockCharts.com

CEFs are funds that are closed for new investment and share creation, unlike ETFs, which have an open creation/redemption feature.

That trait means CEFs often trade at premiums or discounts to net asset value because arbitragers in the market can’t turn to the creation/redemption system to keep the market price linked to fair value, according to ETF.com Analytics.

It is in those premiums and discounts that a lot of the income opportunity lies. In theory, CEFs that trade at a discount to NAV could deliver a chance at price appreciation. It’s also the case that an “undervalued” CEF would enhance the overall yield of a fund relative to the price paid for that position. That’s why these ETFs tend to focus on the CEFs that show the greatest discounts.


PCEF, for example, is a “fund of funds” that tracks an index consisting of investment-grade and high-yield closed-end funds. The fund also includes an equity option-writing strategy, in a portfolio that assigns heavier weightings to larger CEFs that trade at a discount. In fact, the average discount by which the market price of a CEF in the fund is less than its NAV is currently 7.42 percent.

The $504.7 million ETF has a current 30-day SEC yield of 7.54 percent and a distribution yield of 8.41 percent, according to data on the issuer’s website. To put that yield into perspective, a 10-Year Treasury is delivering 2.70 percent.

But PCEF owns 149 closed-end funds, or three times as many CEFs as YYY owns. What’s more, the ETF is heavily allocated to fixed income—about 60 percent of the portfolio is linked to that asset class. That profile compares with YYY’s heavier focus on equities, and broader diversification overall, making YYY more of a strategic play than a beta fund.

There’s no question that YYY’s profile—58 percent allocated to equities CEFs and 4 percent linked to multi-asset CEFs—would make the overall portfolio less sensitive to changes in interest rates than PCEF. As interest rates rise, bond prices drop.

“The concept hinges on the success of buying discounted closed-end funds with big yields and enough liquidity to minimize trading costs within the basket,” ETF.com ETF Analytics says of YYY. “In order to optimize yield, YYY can hold closed-end funds focused on all of the major asset classes, capping the weight of the 30 funds at a maximum of 4.5 percent at rebalance.”

YYY owns only 30 CEFs, with an average discount of 5.94 percent. The fund is delivering a 30-day SEC yield of 8.4 percent.

“CEFs have had a rollercoaster ride the last 12 months,” Wela’s Mitch Reiner told ETF.com, pointing to opportunities in the space. “They exhibited significant value recently with premium/discounts and the ‘z-scores’ associated with them, uncharacteristically cheap during this period of time where borrowing costs were so low.”

Opportunities aside, Reiner also cautioned against buying into CEFs—and CEF ETFs—based on a single metric such as discounts, because pockets of the market can change, and cheap funds could get cheaper before they go higher.

Discounts relative to NAV are already above the historical norm—which is 4.5 percent, based on a 14-year average—and could widen further if interest rates rise, potentially leading to NAV losses. It could also be that increasing demand for CEFs would compress the spread.

So far in 2014, PCEF has attracted a net of $8.5 million in net inflows, while YYY has gathered a net of $5.7 million year-to-date.


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